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The Fed and the U.S. National Debt

The U.S. Federal Reserve gets a lot of attention for setting interest rates as part of its role in directing the country’s monetary policies, but not many Americans realize the extent to which it has contributed to growing the size of the U.S. national debt and the problems associated with having such large liabilities on the nation’s books.

Writing at Economics21, Dennis Jansen and Thomas Saving explain that role and how the Fed’s policies will make it harder to tackle the national debt in the future.

It is not widely recognized that the Fed is a source of federal government revenue. The Fed creates money and uses that money to purchase assets, typically government bonds. These assets earn interest, generating revenue for the Fed. After paying its expenses, the Fed returns the remainder of its revenues to the U.S. Treasury, which has been used to service the federal debt. In 2006, prior to the financial crisis and the Great Recession, the Fed held assets of $873.4 billion and had relatively few actual liabilities. That year, the Fed’s interest earnings were $36.8 billion and interest expenses were $1.3 billion. After paying operating expenses, the Fed returned $29.1 billion to the Treasury.

In the aftermath of the Great Recession several changes occurred. First, the Fed greatly expanded both the assets and liabilities on its balance sheet. In doing so, it created an equally large amount of funds in the form of either reserves or currency. Second, in order to keep the money supply from expanding proportionally with the increase in assets—that is, in order to keep inflation in check—the Fed began for the first time to pay interest on bank reserves. The Fed did this to give banks an incentive to hold part of the newly issued funds as bank reserves in lieu of putting these funds into circulation. Third, because the interest rate on Fed assets was greater than the interest rate on these bank reserves, the interest earned on the increase in Fed assets exceeded the interest it paid on the higher bank reserves.

The net effect was a large increase in both Fed net revenue and, therefore, in Fed payments to the Treasury. In fact, by 2010, the Fed was financing 39% of the interest cost of the Federal debt—and such high levels of financing continued through 2016, when Fed transfers to the Treasury reached $100 billion and covered 48% of the interest cost of the debt. But since 2016, the Fed has been covering less of that cost. In fiscal year 2018, the debt service cost was $322 billion and Fed transfers are projected to be $60 billion, or only 21% of the debt servicing cost. The Congressional Budget Office projects that by 2019, Fed transfers will cover only 11% of debt servicing cost—and by 2020, that the Fed will cover less than 10% of a debt service cost of $485 billion. This decline is dramatic: in a mere four years, the Fed will move from covering half of the debt servicing cost and one quarter of the deficit to under 10% of debt servicing and 5% of the deficit.

The authors don’t mention it, but several economists believe the Fed’s introduction of its policy to pay interest on reserves in 2008 is what transformed the 2008 recession into what we now call the Great Recession by sparking a greater contraction of the nation’s economy.

The Fed then sought to correct that problem through its Quantitative Easing programs, where the Fed became one of the leading lenders to the U.S. government, enabling the unprecedented peacetime escalation of the national debt. The money that the Fed then “earned” from the U.S. government-issued debt they accumulated covered the cost of a large portion of the increased cost of having taken on so much debt, making it appear more affordable for U.S. taxpayers than it really was.

Now that the Fed has changed its policies and is seeking to unwind its holdings of U.S. government-issued debt securities, and has increased interest rates, U.S. taxpayers will be forced to bear a larger burden in paying for the full cost of the debt that the U.S. government racked up during the Great Recession, which will make it that much harder to restrain the growth of the national debt and to pay the government’s other bills more than a decade after the government’s debts were originally accrued.